Property held outside of superannuation is generally able to be geared and asset improvement can be funded by debt.
However, these options are generally not available to superannuation funds due to the prohibition against borrowing.
Limited Recourse Borrowing Arrangements
An exception to the borrowing prohibition was introduced in September 2007 in the form of limited recourse borrowing arrangements. In July 2010, the rules relating to these arrangements were further clarified.
Such arrangements are subject to a number of restrictions. Some of the restrictions are:
- The borrowing must be limited recourse; namely, the lender’s right of recourse is limited to the underlying assets subject to the borrowing. In other words, the lender does not have any recourse against the other assets of the superannuation fund. In some circumstances, this causes the bank to require a lower LVR or higher interest rate;
- Borrowings are permitted for the acquisition of an asset and for making repairs to the asset, but cannot be applied to make improvements to an asset;
- Where borrowings are applied to acquire an asset, the superannuation fund cannot make significant improvements to the asset, even if those improvements are made with cash reserves and borrowings are not required.
There are other conditions that must be satisfied for limited recourse borrowing arrangements, however these are outside the scope of this article.
Options for consideration
Option 1: Ungeared Trust as an alternative to limited recourse borrowing arrangements
A client may be looking at alternatives to a limited recourse borrowing arrangement, perhaps because their own bank does not offer those arrangements or imposes stringent conditions.
Nevertheless, they may have a sum of money in their superannuation fund which they wish to utilise for an acquisition and would also like the option of their superannuation fund increasing its interest over time.
The legislation generally prohibits superannuation funds from investing in closely held trusts. One of the exceptions from this prohibition is an investment in what might be termed Ungeared Trusts, namely trusts that satisfy conditions that are set out in the regulations.
This exception would allow the superannuation fund to invest its funds by acquiring units in the Ungeared Trust, and a related party to invest the remaining funds that are required for the acquisition. Those funds may be financed by fully recourse bank loans to the related party, provided the asset to be acquired is not required as security for those borrowings. Should it become desirable that the superannuation fund increase its interest in the asset, the superannuation fund may acquire units from the related party. The acquisition of those units is excluded from the prohibition against acquiring assets from related parties.
Option 2: Ungeared Trust to overcome restrictions against improvements
Where it is proposed to acquire an asset and make significant improvements to that asset subsequent to acquisition, and borrowings are required for the acquisition and/or the improvement, a limited recourse borrowing arrangement may be considered in conjunction with an Ungeared Trust.
In essence, there is an investment by the superannuation fund in the Ungeared Trust, whether or not it involves borrowing. If it does involves borrowing, the unit holder will be the Warrant Trust under the limited recourse borrowing arrangement.
When it is desirable or necessary to make improvements, the superannuation fund can obtain funding under a limited recourse borrowing arrangement to fund an acquisition of a second tranche of units in the Ungeared Trust. The underlying asset cannot be used as security for the borrowing. Provided security outside of superannuation is available, the borrowing could be applied by the superannuation fund to acquire further units in the Ungeared Trust, and the funds from that investment could be applied by the trustee of the Ungeared Trust to make the improvement. The borrowing has been applied to acquire a separate asset, namely units in the Trust. The restriction against improvements does not apply because the asset of the superannuation fund is the units in the Ungeared Trust and the improvements are not made to that asset.
The same process can be applied if it is proposed to split the asset into several assets (for example, a subdivision or the removal of a structure overlapping 2 separate titles which results in the asset ceasing to be a single acquirable asset – another condition of limited recourse borrowing arrangements).
Option 3: Unrelated Trusts
Whilst the legislation generally prohibits an investment in closely held trusts, this only applies where the closely held trust is controlled by a group relating to the superannuation fund in one of the three ways set out in the legislation.
This means that where an acquisition involves two or more unrelated family groups (for example two or more business associates not related by blood), their superannuation funds may invest in a unit trust that is structured in a way that the group associated with any one superannuation fund does not control the trust in one of the three ways.
Where the unrelated family groups are business associates, the structure of the business must also be considered.
The advantage of this kind of trust is that it is not subject to the restrictions that apply to superannuation funds. Importantly, they are not subject to the limited recourse borrowing arrangements, and are therefore able to borrow on full recourse terms and to make improvements and are able to borrow on the security of other assets held in the unit trust. They therefore provide a more flexible means of gearing the acquisition and improvement of an asset. In addition, in certain circumstances it is possible for one of the superannuation funds to provide additional monies by way of loan directly to the unit trust, provided it is made on arm’s-length terms.
- Most advisers, when considering acquisitions by superannuation funds, focus on limited recourse borrowing arrangements.
- In many circumstances, the restrictions applying to those arrangements make them unsuitable.
- There are often other options that can be considered to achieve your objective.